EXHIBIT 13.1
LETTER FROM THE CEO [PHOTO]
TO OUR SHAREHOLDERS
TO OUR SHAREHOLDERS
Fiscal 2004 was another successful year for CHAD Therapeutics. Revenue and net
income reached 7 year highs on the strength of a 14% gain in sales of our core
oxygen conserver products. International sales increased 16% over the prior
year, also primarily the result of higher conserver sales. As a result, CHAD's
share of the conserver market increased again in fiscal 2004, confirming that
our strategy to offer the widest array of choices in conserver products
continued to move us in the right direction. The performance capabilities,
reliability, cost-effectiveness and selection afforded by our OXYMATIC(R) 400
Series electronic conservers and CYPRESS OXYPneumatic(R) conservers give us a
strong platform for growth.
Our product portfolio will continue to expand. Even as we invested in our
traditional product lines during fiscal 2004, we also launched the first in a
planned family of oxygen therapeutic devices and moved forward with our
development programs related to our licensed technologies. As we reported to you
last year, we are pursuing these technologies to help us expand our home oxygen
product offerings and potentially to allow us to enter the high-growth sleep
disorder market. We currently expect to begin clinical trials of our new sleep
disorder products early in the current fiscal year. It is especially noteworthy
that we achieved sharply higher profitability for fiscal 2004 even after a 31%
increase in R&D spending to support our new product pipeline, with funding
provided entirely from internal sources.
We also expanded our distributor network, added key senior staff in sales and
marketing, and announced important promotions. Our people are dedicated,
experienced, and committed to CHAD's continued success. With progress on the top
line, the bottom line and the pipeline, we are optimistic about the future of
CHAD Therapeutics.
FINANCIAL RESULTS
For the fiscal year ended March 31, 2004, revenue increased 10% to $21,541,000
from $19,541,000 for fiscal 2003. Net income for fiscal 2004 increased to
$1,001,000, or $0.10 per diluted share. This compares to a net loss for fiscal
2003 of $433,000, or $0.04 per diluted share, which included a non-cash charge
of $934,000 for the write-off of an intangible license fee asset associated with
the TOTAL O(2) (R) Delivery System. The operating results for 2004 and 2003 also
included $125,000 and $165,000, respectively, in unanticipated expenses incurred
in connection with proxy contests waged by a group of dissident shareholders who
attempted unsuccessfully to elect nominees to CHAD's Board.
CHAD's financial position is strong. At March 31, 2004, cash increased to
$2,708,000 compared to $1,596,000 at the end of fiscal 2003. CHAD has no
long-term debt. The Company generated $1,719,000 in positive cash flow from
operating activities in fiscal 2004, which allowed us to fund our growth and
investments in new products and technologies for the future.
NEW OXYGEN THERAPEUTIC DEVICE
We recently received FDA clearance to market our new SAGE(TM) Oxygen Therapeutic
Device. SAGE combines the industry's first truly dynamic delivery technology
with the proven oxygen sensor technology in our OXYMATIC 400 series conserver to
create a therapeutic device that maximizes patient ambulatory capability by
addressing the common problem of oxygen desaturation, which causes a patient to
feel weak and out of breath when activity increases.
The first in a planned family of oxygen therapeutic devices that use our
proprietary technologies to sense a patient's movements and automatically adjust
the rate of oxygen delivery to reduce the risk of desaturation, the SAGE device
extends the long history of product innovation at CHAD. This exciting new device
underscores our position as a technological leader in the development of home
respiratory products and demonstrates our dedication to providing home care
suppliers and their patients with the widest range of home oxygen products to
suit individual needs, preferences and disease conditions.
THE CHANGING HOME CARE LANDSCAPE
We expect the Medicare Improvement and Modernization Act signed into law in
December 2003 to exert continued pressure on home care providers to reduce the
overall cost of providing home oxygen services. In the short run, this is likely
to affect CHAD's profit margins on domestic conserver sales, although it also
has created opportunities for us to increase our market share and offset the
price pressure with cost reductions in our products. Longer term, we believe the
impact of the new Medicare legislation may accelerate the move to more
cost-effective technologies such as CHAD's proprietary technology contained in
our TOTAL O(2) Delivery System.
1
TO OUR SHAREHOLDERS
Interest in our TOTAL O(2) home oxygen system has increased since the enactment
of the legislation, and a number of product evaluations are under way with
potential customers. We also are seeing an increase in international interest in
this product. The TOTAL O(2) system provides a safe, reliable and efficient
means for patients to fill their portable oxygen cylinders at home and thereby
gain independence and complete control over their oxygen supplies. At the same
time, the system can help home healthcare providers reduce service and delivery
costs and cylinder inventories, yielding savings which quickly offset the
system's higher initial capital cost. The recent changes in Medicare
reimbursement make cost control an increasingly urgent priority for home care
providers. While it is still too soon to predict that our TOTAL O(2) system will
become a significant contributor to CHAD's growth, we remain convinced that the
opportunity is real and that our marketing initiatives put us on the right track
to build awareness and demand.
EARL YAGER NAMED CEO
In April 2004 we announced that Earl L. Yager, previously President, Chief
Financial Officer and Secretary, was named President and Chief Executive
Officer. Earl succeeds Thomas E. Jones, who had been CEO since 1998 and who will
remain Chairman of the Board, focusing on the development of additional
marketing, partnering, and new product opportunities for CHAD.
Earl has been President of CHAD Therapeutics since January 1, 2003, Chief
Operating Officer from September 2000 through December 2002, Chief Financial
Officer since 1983 and a director and Secretary since 1988. He is a certified
public accountant. Earl has amply demonstrated his leadership and effectiveness
in managing our business. He has made critical contributions to our strategy to
enhance CHAD's leadership in the conserver segment of the oxygen therapy market
as well as our plans to enter new growth markets in oxygen therapy and related
fields. His efforts to increase manufacturing efficiency, improve margins and
reduce costs also have met with significant success. All of us at CHAD
congratulate Earl on this well-earned promotion.
We also announced the promotion of Tracy Kern to Chief Financial Officer,
succeeding Earl at that position. Tracy had been Cost Accounting Manager since
she joined CHAD in January 2003. From 1997 to 2002, she served in various
positions with KPMG LLP, most recently as Audit Manager. We welcome Tracy to our
senior management team.
In another important addition to our team, Len Serafino was named Regional Vice
President of Sales, where he will be responsible for managing CHAD's sales
program in most of the Eastern United States, and for developing and managing
the Company's sales strategy for the sleep disorder products currently under
development. Len brings to CHAD more than 20 years of senior sales, marketing
and operating experience, most recently as Vice President of Purchasing at
American HomePatient, a national home care provider chain. With this strong
background, Len is uniquely qualified to help us expand the market for CHAD's
TOTAL O(2) system, and develop a successful strategy for selling the new
products we expect to introduce to the sleep disorder market later this year.
Finally, and with regret, we announce that the Company will be losing the
services of Norman Cooper, a valued member of our Board of Directors since 1986.
Norm, who is retiring at this year's annual meeting, made many important
contributions to CHAD's growth and development over the years. His wise advice
and counsel will be missed. All of us at CHAD thank Norm for his support over
the years and wish him the best.
A LOOK AHEAD
CHAD's success reflects our diligent pursuit of a sound strategic plan to
provide advanced oxygen and related products that improve patient care and help
control costs. We made important progress during fiscal 2004. We expanded our
conserver product line and launched the first of a new family of therapeutic
oxygen products, moved forward in our R&D program to develop new products for
the sleep disorder market, and continued to promote the cost and patient
benefits of our TOTAL O(2) home oxygen system to potential customers.
Each of these efforts will continue in fiscal 2005. We expect another year of
revenue and earnings growth.
We thank our customers for their support, our employees for their diligence, and
our shareholders for their vote of confidence in CHAD's future. We look forward
to reporting our progress to you.
/s/ Earl L. Yager /s/ Thomas E. Jones
Earl L. Yager Thomas E. Jones
Chief Executive Officer Chairman
2
SELECTED FINANCIAL DATA
YEARS ENDED MARCH 31,
-------------------------------------------------------------------------------------
SELECTED FINANCIAL DATA 2004 2003 2002 2001 2000
----------- ---------- ---------- --------- ----------
Net Sales $21,541,000 19,541,000 19,006,000 12,400,000 13,019,000
Interest Income, Net 22,000 20,000 50,000 87,000 43,000
Net Earnings (loss) 1,001,000 (433,000) 1,157,000 (3,011,000) (2,511,000)
Basic Earnings (loss) Per Share .10 (.04) .12 (.30) (.25)
Diluted Earnings (loss) Per Share .10 (.04) .11 (.30) (.25)
Net Working Capital 9,175,000 8,224,000 7,497,000 5,847,000 8,389,000
Total Assets 13,043,000 12,105,000 12,323,000 10,788,000 13,583,000
Shareholders' Equity 11,153,000 10,100,000 10,373,000 9,211,000 12,207,000
No cash dividends have been declared or paid during the periods presented.
3
BALANCE SHEETS
MARCH 31,
--------------------------------
2004 2003
------------ ----------
ASSETS
Current assets:
Cash $ 2,708,000 1,596,000
Accounts receivable, less allowance for doubtful
accounts of $68,000 and $112,000 in 2004 and 2003, respectively 2,911,000 2,517,000
Income taxes refundable -- 4,000
Inventories (Note 2) 4,989,000 5,511,000
Prepaid expenses 233,000 601,000
Deferred income taxes 224,000 --
------------ ----------
Total current assets 11,065,000 10,229,000
------------ ----------
Property and equipment, at cost:
Office equipment and furniture 1,809,000 1,990,000
Machinery and equipment 877,000 972,000
Tooling 1,283,000 1,432,000
Leasehold improvements 1,820,000 1,821,000
------------ ----------
5,789,000 6,215,000
Less accumulated depreciation and amortization 4,571,000 4,979,000
------------ ----------
Net property and equipment 1,218,00 1,236,000
------------ ----------
Intangible assets, net (Note 4) 729,000 562,000
Other assets 31,000 78,000
------------ ----------
$ 13,043,000 12,105,000
============ ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 502,000 741,000
Accrued expenses (Note 7) 1,185,000 1,263,000
Income taxes payable (Note 3) 203,000 1,000
------------ ----------
Total current liabilities 1,890,000 2,005,000
------------ ----------
Commitments (Note 8)
Shareholders' equity (Note 5):
Common shares, no par value
Authorized 40,000,000 shares;
10,096,000 and 10,076,000 shares issued and outstanding 13,309,000 13,257,000
Accumulated deficit (2,156,000) (3,157,000)
------------ ----------
Net shareholders' equity 11,153,000 10,100,000
------------ ----------
$ 13,043,000 12,105,000
============ ==========
See accompanying notes to financial statements.
4
STATEMENTS OF OPERATIONS
YEARS ENDED MARCH 31,
------------------------------------------------
2004 2003 2002
----------- ---------- ----------
Net sales $21,541,000 19,541,000 19,006,000
Cost of sales 12,070,000 11,190,000 11,839,000
----------- ---------- ----------
Gross profit 9,471,000 8,351,000 7,167,000
Costs and expenses:
Selling, general and administrative 7,212,000 7,810,000 6,231,000
Research and development 1,292,000 989,000 819,0000
----------- ---------- ----------
Total costs and expenses 8,504,000 8,799,000 7,050,000
----------- ---------- ----------
Operating income (loss) 967,000 (448,000) 117,000
Interest income, net 22,000 20,000 50,000
Other income 12,000 -- --
----------- ---------- ----------
Earnings (loss) before income taxes 1,001,000 (428,000) 167,000
Income tax expense (benefit) (Note 3) -- 5,000 (990,000)
----------- ---------- ----------
Net earnings (loss) $ 1,001,000 (433,000) 1,157,000
=========== ========== ==========
Basic earnings (loss) per share $ .10 (.04) .12
=========== ========== ==========
Diluted earnings (loss) per share $ .10 (.04) .11
=========== ========== ==========
Weighted shares outstanding:
Basic 10,084,000 10,071,000 10,053,000
Diluted 10,362,000 10,071,000 10,386,000
=========== ========== ==========
See accompanying notes to financial statements.
5
STATEMENTS OF
SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED MARCH 31, 2004,
2003, AND 2002
COMMON SHARES (NOTE 5)
---------------------------- ACCUMULATED
SHARES AMOUNT DEFICIT
---------- ----------- ----------
Balance at March 31, 2001 10,052,000 $13,092,000 (3,881,000)
Exercise of stock options 7,000 5,000 --
Net earnings -- -- 1,157,000
---------- ----------- ----------
Balance at March 31, 2002 10,059,000 13,097,000 (2,724,000)
Exercise of stock options 17,000 20,000 --
Stock options granted as part of
technology acquisition -- 140,000 --
Net loss -- -- (433,000)
---------- ----------- ----------
Balance at March 31, 2003 10,076,000 13,257,000 (3,157,000)
Exercise of stock options 20,000 26,000 --
Stock options granted as part of
technology acquired -- 23,000 --
Tax benefit from exercise of
non-qualified stock options -- 3,000 --
Net earnings -- -- 1,001,000
---------- ----------- ----------
Balance at March 31, 2004 10,096,000 $13,309,000 (2,156,000)
========== =========== ==========
See accompanying notes to financial statements.
6
STATEMENTS OF
CASH FLOWS
YEARS ENDED MARCH 31,
-------------------------------------------------
2004 2003 2002
----------- --------- ----------
Cash flows from operating activities:
Net earnings (loss) $ 1,001,000 (433,000) 1,157,000
Adjustments to reconcile net earnings (loss)
to net cash provided by (used in) operating activities:
Depreciation and amortization 450,000 768,000 902,000
Loss on write down of intangible asset -- 934,000 --
Loss on asset disposition 57,000 -- --
Changes in assets and liabilities:
Decrease (increase) in accounts receivable (394,000) (184,000) 19,000
Decrease (increase) in inventories 522,000 (227,000) (1,869,000)
Decrease (increase) in income taxes refundable 4,000 991,000 (995,000)
Decrease (increase) in prepaid expenses 368,000 (286,000) 283,000
Decrease (increase) in other assets 47,000 (41,000) (17,000)
Decrease (increase) in deferred income taxes (224,000) -- --
Increase (decrease) in accounts payable (239,000) (36,000) 312,000
Increase (decrease) in accrued expenses (78,000) 94,000 60,000
Increase (decrease) in income taxes payable 205,000 (3,000) 1,000
----------- --------- ----------
Net cash provided by (used in) operating activities 1,719,000 1,577,000 (147,000)
----------- --------- ----------
Cash flows from investing activities:
Additions to other assets (146,000) (278,000) --
Capital expenditures (487,000) (243,000) (398,000)
Proceeds from sale of property and equipment -- -- 1,000
----------- --------- ----------
Net cash used in investing activities (633,000) (521,000) (397,000)
----------- --------- ----------
Cash flows from financing activities:
Exercise of stock options 26,000 20,000 5,000
----------- --------- ----------
Net cash provided by financing activities 26,000 20,000 5,000
----------- --------- ----------
Net increase (decrease) in cash 1,112,000 1,076,000 (539,000)
Cash beginning of year 1,596,000 520,000 1,059,000
----------- --------- ----------
Cash end of year $ 2,708,000 1,596,000 520,000
=========== ========= ==========
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest $ -- 2,000 6,000
Income taxes 13,000 15,000 4,000
=========== ========= ==========
Supplemental schedule of non-cash investing and financing activities:
Tax benefit from exercise of non-qualified stock options $ 3,000 -- --
=========== ========= ==========
See accompanying notes to financial statements.
7
NOTES TO FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
THE COMPANY
CHAD Therapeutics, Inc. (the Company) is in the business of developing,
producing and marketing respiratory care devices designed to improve the
efficiency of oxygen delivery systems for home health care and hospital
treatment of patients suffering from pulmonary diseases.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments approximate fair value as of March
31, 2004 and 2003. The carrying amounts related to cash, accounts receivable,
other current assets, and accounts payable approximate fair value due to the
relatively short maturity of such instruments.
INVENTORIES
Inventories are valued at lower of cost or market. Cost is determined based on
standard cost which approximates the first-in, first-out method.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation of property and
equipment is provided using the straight-line method based on the estimated
useful lives of the related assets as follows:
Office Equipment and Furniture 5-10 Years
Machinery and Equipment 5-10 Years
Tooling 4 Years
Amortization of leasehold improvements is over the life of the related lease or
asset, whichever is shorter.
USE OF ESTIMATES
Management of the Company has made a number of estimates and assumptions
relating to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities at the balance sheet date and the reporting of
revenues and expenses during the periods to prepare these financial statements
in conformity with accounting principles generally accepted in the United States
of America. Actual results could differ from those estimates.
Significant estimates include the allowance for doubtful accounts, inventory
valuation, deferred income tax asset valuation allowances, and the estimated
future operating cash flows from the Company's long-lived assets, including its
intangible assets. Considerable management judgement is necessary to estimate
future operating cash flows as future cash flows are impacted by competitive and
other factors that are generally out of management's control. Accordingly,
actual results could vary significantly from management's estimates.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company reviews its long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to undiscounted future net cash
flows expected to be generated by the asset. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which the
carrying amount of the assets exceeds the fair value of the assets.
REVENUE RECOGNITION
Revenue from product sales is recognized upon shipment of merchandise. Products
are shipped FOB shipping point and title to the products transfers to the
purchaser upon shipment. Shipping charges billed to customers are included in
net sales. Allowances for customer returns have not been established as
historical experience has been minor. Costs paid to shipping companies are
recorded as a cost of sales.
COMPREHENSIVE INCOME (LOSS)
The Company did not have components of other comprehensive income during the
periods ended March 31, 2004, 2003 and 2002. As a result, comprehensive income
(loss) is the same as net earnings (loss) for the periods ended March 31, 2004,
2003 and 2002.
ROYALTY EXPENSE
The Company charges royalties incurred on product licenses to selling, general
and administrative expenses.
EARNINGS (LOSS) PER COMMON SHARE
Following is a calculation of basic and diluted earnings (loss) per common share
for the years ended March 31, 2004, 2003 and 2002, respectively:
2004 2003 2002
----------- ---------- ----------
Basic earnings per share
Numerator - net earnings (loss) $ 1,001,000 (433,000) 1,157,000
Denominator- weighted common
shares outstanding 10,084,000 10,071,000 10,053,000
----------- ---------- ----------
Basic earnings (loss) per share $ .10 (.04) .12
=========== ========== ==========
Diluted earnings (loss) per share
Numerator - net earnings (loss) $ 1,001,000 (433,000) 1,157,000
Denominator -
Weighted common shares
outstanding 10,084,000 10,071,000 10,053,000
Common stock equivalents 278,000 -- 333,000
----------- ---------- ----------
10,362,000 10,071,000 10,386,000
----------- ---------- ----------
Diluted earnings (loss) per share $ .10 (.04) .11
=========== ========== ==========
8
NOTES TO FINANCIAL STATEMENTS
Options to purchase 379,000, 1,089,000 and 439,000 shares of common stock at
prices ranging from $3.14 to $12.54, $0.50 to $12.54, and from $3.75 to $12.54
per share were not included in the computation of diluted earnings per share in
2004, 2003 and 2002, respectively, because their inclusion would be
anti-dilutive.
INCOME TAXES
Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax basis and net operating
loss and tax credit carryforwards. In assessing whether there is a need for a
valuation allowance on deferred tax assets, we determine whether it is more
likely than not that we will recognize tax benefits associated with deferred tax
assets. In making this determination, we consider future taxable income and tax
planning strategies that are both prudent and feasible. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.
MAJOR CUSTOMER
One national chain customer accounted for 27%, 24% and 23% of net sales during
2004, 2003 and 2002, respectively. Another national chain customer accounted for
14% and 11% of net sales during 2004 and 2003, respectively. The Company's
customers are affected by Medicare reimbursement policy as approximately 80% of
home oxygen patients are covered by Medicare and other government programs.
STOCK OPTION PLAN
The Company accounts for its stock option plan in accordance with the provisions
of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations. The Company has also adopted the pro
forma disclosure provisions of Statement of Financial Accounting Standards
(SFAS) No. 123, Accounting for Stock-Based Compensation, which permits entities
to provide pro forma net income and pro forma net earnings per share disclosures
as if the fair-value-based method defined in SFAS No. 123 had been applied.
The Company applies Accounting Principles Board Opinion No. 25 in accounting for
the Plan and no compensation expense has been recognized for its stock options
in the accompanying financial statements. The following table illustrates the
effect on net earings (loss) and earnings (loss) per share if the Company had
applied the fair value recognition provision of FASB Statement No. 123,
Accounting for Stock-Based Compensation, to stock-based employee compensation:
YEAR ENDED MARCH 31,
2004 2003 2002
------------- -------- -------------
Net earnings (loss), as reported $ 1,001,000 (433,000) $ 1,157,000
Deduct: Total stock-based
employee compensation expense
determined under fair value-
based method for all awards,
net of related tax effects (81,000) (147,000) (169,000)
Pro forma net earnings (loss) 920,000 (580,000) 988,000
Earnings (loss) per share:
Basic - as reported .10 (.04) .12
Basic - pro forma .09 (.05) .10
Diluted - as reported .10 (.04) .11
Diluted - pro forma .09 (.05) .09
The weighted average fair value of options granted during 2004, 2003 and 2002 is
estimated at $2.69, $1.74 and $2.04, respectively. The disclosure of
compensation cost under this pronouncement may not be representative of the
effects on net earnings (loss) for future years. The fair value of options
granted during each period was estimated using the Black-Scholes option pricing
model with the following assumptions:
2004 2003 2002
----- ---- ----
Risk-free interest rate 3.9% 5.9% 5.9%
Forfeiture rate 2.0% 2.0% 2.0%
Dividend yield .0 .0 .0
Volatility 82% 86% 89%
Expected life (years) 10.0 5.0 5.0
SEGMENT INFORMATION
The Company operates in one segment, the respiratory care market.
RECLASSIFICATIONS
Certain reclassifications have been made to the prior year's balances to conform
to the 2004 presentation.
(2) INVENTORIES
At March 31, 2004 and 2003, inventories consisted of the following:
2004 2003
----------- ---------
Finished goods $ 1,223,000 1,245,000
Work in process 1,062,000 1,382,000
Raw materials
and supplies 2,704,000 2,884,000
----------- ---------
$ 4,989,000 5,511,000
=========== =========
9
NOTES TO FINANCIAL STATEMENTS
(3) INCOME TAXES
Income tax expense (benefit) for fiscal 2004, 2003, and 2002 consisted of the
following:
2004 2003 2002
--------- ----- --------
Current:
Federal $ 204,000 3,000 (995,000)
State 16,000 2,000 5,000
--------- ----- --------
220,000 5,000 (990,000)
Deferred:
Federal (204,000) -- (6,000)
State (16,000) -- 6,000
--------- ----- --------
(220,000) -- --
--------- ----- --------
Total $ -- 5,000 (990,000)
========= ===== ========
A reconciliation of the difference between the Company's for income tax expense
(benefit) and the statutory income tax for the years ended March 31, 2004, 2003
and 2002, respectively, is as follows:
2004 2003 2002
---------- -------- ----------
Statutory tax
expense (benefit) $ 341,000 (145,000) 57,000
State income tax, net -- (22,000) 6,000
Valuation allowance (383,000) 157,000 (1,030,000)
Warranty and other 42,000 15,000 (23,000)
---------- -------- ----------
$ -- 5,000 (990,000)
========== ======== ==========
The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets at March 31, 2004 and 2003 are presented as follows:
2004 2003
----------- ----------
Bad debt reserves $ 29,000 47,000
Accrued expenses 286,000 269,000
Inventories 70,000 71,000
Depreciation and Amortization 391,000 379,000
Intangible assets 373,000 393,000
Net Operating Loss 226,000 343,000
Other 5,000 53,000
----------- ----------
Total deferred tax assets 1,380,000 1,555,000
Deferred tax liabilities:
State Taxes (152,000) (168,000)
----------- ----------
Subtotal 1,228,000 1,387,000
Valuation Allowance (1,004,000) (1,387,000)
----------- ----------
Net deferred tax assets $ 224,000 --
=========== ==========
In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will be realized. At March 31, 2004, the Company's net deferred tax
assets are partially offset by a valuation allowance. The Company will continue
to assess the valuation allowance and to the extent it is determined that such
allowance is no longer required, the tax benefit of the remaining net deferred
tax assets will be recognized in the future. The Company has California net
operating loss carry forwards of $2,785,000, respectively. The State of
California has suspended the utilization of net operating loss carryforwards
during tax years starting in 2002 and 2003. As a result, the Company will be
unable to use its California net operating loss carryforwards until the tax year
beginning April 1, 2004. The Federal and California net operating losses expire
in 2021 and 2006, respectively.
(4) INTANGIBLE ASSETS
Intangible assets include amounts paid for licenses on new and existing
products. License fees are being amortized using the straight-line method over
the life of the related patents. Accumulated amortization on the license fees
amounted to $17,000 and $15,000 at March 31, 2004 and 2003, respectively. Annual
amortization on intangible assets currently in service will be $39,000 for each
of the next five years. During 2003, the company wrote off a license fee asset
that had a net book value of $934,000 in accordance with the provisions of FASB
Statement No. 144, Accounting for the Impairment of Long-Lived Assets and
Long-Lived Assets to be Disposed Of, Net intangible assets were $729,000 and
$562,000 at March 31, 2004 and 2003, respectively.
(5) SHAREHOLDERS' EQUITY
The Company has an incentive stock option plan (the Plan) for key employees as
defined under Section 422(A) of the Internal Revenue Code. The Plan as amended,
provides that 1,509,000 common shares be reserved for issuance under the Plan,
which expires on September 10, 2004. In addition, the Plan provides that
non-qualified options can be granted to directors and independent contractors of
the Company. Transactions involving the stock option plan are summarized as
follows:
WEIGHTED
AVERAGE
OPTION PRICE
SHARES PER SHARE
------- ----------
Incentive Options:
Outstanding - March 31, 2001 839,000 3.22
Cancelled (25,000) 3.20
Granted 75,000 3.37
Exercised (7,000) .71
------- ----------
Outstanding - March 31, 2002 882,000 3.25
Cancelled (120,000) 9.32
Granted 77,000 2.49
Exercised (17,000) 1.18
Expired (33,000) 1.85
------- ----------
Outstanding - March 31, 2003 789,000 2.37
Cancelled (16,000) 3.44
Granted 15,000 2.80
Exercised (9,000) .78
------- ----------
Outstanding - March 31, 2004 779,000 2.37
------- ----------
Exercisable - March 31, 2004 616,000 $1,458,000
======= ==========
10
NOTES TO FINANCIAL STATEMENTS
Non-qualified Options:
Outstanding - March 31, 2001 171,000 8.23
Granted 19,000 1.00
------- ----------
Outstanding - March 31, 2002 190,000 7.50
Cancelled (10,000) 8.90
Granted 120,000 2.27
------- ----------
Outstanding - March 31, 2003 300,000 5.37
Cancelled (42,000) 8.20
Granted 75,000 2.04
Exercised (11,000) 1.58
------- ----------
Outstanding - March 31, 2004 322,000 $1,408,000
======= ==========
Exercisable - March 31, 2004 157,000 $1,061,000
======= ==========
At March 31, 2004, information regarding outstanding options is summarized as
follows:
RANGE OF EXERCISE PRICES
$ .50-6.69 7.63-12.54
---------- ----------
Number outstanding 1,020,000 81,000
Weighted average
remaining life (yrs.) 6.4 2.1
Weighted average
exercise price $ 2.28 11.22
Number exercisable 692,000 81,000
Weighted average
exercise price $ 2.32 11.22
Incentive and non-qualified options were granted at prices not less than 100% of
market value at dates of grant. Options under the Plan become exercisable on the
anniversary of the grant date on a prorata basis over a defined period and
expire 10 years after the date of grant. To the extent the Company derives a tax
benefit from options exercised by employees, such benefit is credited to Common
Shares when realized on the Company's income tax returns.
(6) EMPLOYEE BENEFIT PLAN
In December, 1992, the Company adopted a defined contribution profit sharing
plan, including features under Section 401(k) of the Internal Revenue Code. The
purpose of the plan is to provide an incentive for employees to make regular
savings for their retirement. Company contributions to the profit sharing plan
are discretionary and are determined by the Board of Directors. There were no
contributions in 2004, 2003 and 2002.
(7) ACCRUED EXPENSES
Accrued expenses consist of the following:
2004 2003
---------- ---------
Accrued royalties $ 374,000 488,000
Product and business
liability insurance -- 94,000
Deferred rent 24,000 4,000
Accrued vacation 181,000 147,000
Warranty expense 103,000 140,000
Payroll and incentive
compensation 172,000 121,000
Customer Deposits 120,000 46,000
Other 211,000 223,000
---------- ---------
$1,185,000 1,263,000
========== =========
(8) COMMITMENTS
The Company is currently leasing its administrative and plant facilities and
certain office equipment under noncancelable operating leases which expire
through June, 2008.
The Company's minimum annual rental commitments under these leases are as
follows:
2005 $ 406,000
2006 422,000
2007 436,000
2008 451,000
2009 113,000
Thereafter 0
----------
TOTAL: $1,828,000
==========
Rent expense amounted to $552,000, $469,000, and $470,000 for the years ended
March 31, 2004, 2003 and 2002, respectively.
The Company has minimum annual royalty requirements pursuant to the terms of
license agreements related to certain products in the amount of $515,000. Annual
royalty expense on all products amounted to $776,000, $1,102,000, and $1,136,000
for the years ended March 31, 2004, 2003 and 2002, respectively. License
agreements with minimum annual royalty requirements are in place through fiscal
year 2012.
The Company is involved in certain legal actions resulting from the ordinary
course of business. The Company believes the ultimate outcome of the legal
actions will not have a material adverse impact on the Company's financial
statements as a whole.
(9) GEOGRAPHIC INFORMATION
The Company has one reportable operating segment as defined in Note 1.
Geographic information regarding the Company's net sales is as follows:
2004 2003 2002
----------- ---------- ----------
United States $20,498,000 18,639,000 17,904,000
Canada 303,000 307,000 265,000
Japan 238,000 207,000 240,000
Germany 44,000 46,000 289,000
All other countries 458,000 342,000 308,000
----------- ---------- ----------
$21,541,000 19,541,000 19,006,000
=========== ========== ==========
All long-lived assets are located in the United States.
Sales of OXYMATIC(R) and CYPRESS conservers accounted for 77%, 74% and 60% of
the Company's net sales for the years ended March 31, 2004, 2003 and 2002,
respectively.
11
NOTES TO FINANCIAL STATEMENTS
(10) VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
The following is the Company's schedule of activity in the valuation and
qualifying accounts and reserves for the years ended March 31, 2004, 2003 and
2002:
BALANCE AT CHARGED TO BALANCE
BEGINNING COSTS AND AT END
OF YEAR EXPENSES DEDUCTIONS OF YEAR
-------- ---------- ---------- -------
ALLOWANCE FOR
DOUBTFUL ACCOUNTS:
2002 33,000 64,000 21,000 76,000
2003 76,000 97,000 61,000 112,000
2004 112,000 7,000 51,000 68,000
WARRANTY RESERVE:
2002 134,000 32,000 5,000 161,000
2003 161,000 15,000 36,000 140,000
2004 140,000 22,000 59,000 103,000
(11) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table presents summarized unaudited quarterly financial data for
2004 and 2003:
BASIC &
DILUTED
NET EARNINGS
GROSS EARNINGS (LOSS)
REVENUE PROFIT (LOSS) PER SHARE
----------- ---------- ---------- ----------
2004
First Quarter $ 5,669,000 $2,518,000 $ 224,000 .02
Second Quarter 5,284,000 2,366,000 150,000 .02
Third Quarter 5,237,000 2,347,000 418,000 .04
Fourth Quarter 5,351,000 2,240,000 209,000 .02
----------- ---------- ---------- ----------
Year $21,541,000 $9,471,000 $1,001,000 .10
=========== ========== ========== ==========
2003
First Quarter $5,022,000 $2,140,000 $ 178,000 $ 0.02
Second Quarter 4,840,000 2,043,000 2,000 0.00
Third Quarter 4,980,000 2,132,000 228,000 0.02
Fourth Quarter 4,699,000 2,036,000 (841,000) $ (0.08)
----------- ---------- ---------- ----------
Year $19,541,000 $8,351,000 $ (433,000) $ (0.04)
=========== ========== ========== ==========
In the fourth quarter of 2003, the Company recorded a complete write down of an
intangible license fee asset in the amount of $934,000.
(12) NEW ACCOUNTING PRONOUNCEMENTS.
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations (SFAS No. 143), SFAS No. 143 requires the Company to record the fair
value of an asset retirement obligation as a liability in the period in which it
incurs a legal obligation associated with the retirement of tangible long-lived
assets that result from the acquisition, construction, development and/or normal
use of the assets. The Company adopted SFAS No. 143 on April 1, 2003. The
Company does not currently have any assets affected by SFAS No. 143.
In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections
which requires that the extinguishment of debt not be considered an
extraordinary item under APB Opinion No. 30, Reporting the Results of Operations
- - Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions,
unless the debt extinguishment meets the unusual in nature and infrequency of
occurrence criteria in APB 30. SFAS No. 145 is effective for fiscal years
beginning after May 15, 2002. The Company adopted SFAS No. 145 on April 1, 2003
and there was material impact on the Company's financial condition or results of
operations.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation
addresses the consolidation by business enterprises of variable interest
entities as defined in the Interpretation. The Interpretation generally applies
immediately to variable interests in variable interest entities created after
January 31, 2003 and to variable interests in variable interest entities
obtained after January 31, 2003. The application of this Interpretation did not
have a material effect on the Company's financial statements. In December 2003,
the FASB revised FIN 46 to exempt certain entities from its requirements and to
clarify certain issues arising during the implementation of FIN 46. The adoption
of this revised interpretation did not have any impact on our financial
statements.
In May 2003, the Financial Accounting Standards Board issued Statement No. 150,
"Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity" (SFAS No. 150). The statement establishes standards for
how an issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. It requires that an issuer
classify a financial instrument that is within its scope as a liability (or an
asset in some circumstances). It is effective for financial instruments entered
into or modified after May 31, 2003, and otherwise is effective at the beginning
of the first interim period beginning after June 15, 2003. We adopted this
standard effective July 1, 2003, and it did not have a material effect on the
Company's financial statements.
12
REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM
The
Board
of
Directors
and
Shareholders
CHAD Therapeutics, Inc.
We have audited the accompanying balance sheets of CHAD Therapeutics, Inc. as of
March 31, 2004 and 2003 and the related statements of operations, shareholders'
equity and cash flows for each of the years in the three-year period ended March
31, 2004. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of CHAD Therapeutics, Inc. as of
March 31, 2004 and 2003 and the results of its operations and its cash flows for
each of the years in the three-year period ended March 31, 2004, in conformity
with accounting principles generally accepted in the United States of America.
[KPMG LLP]
Los Angeles, California
April 23, 2004
13
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATION
OVERVIEW
The Company develops, assembles and markets medical devices that furnish
supplementary oxygen to home health care patients. The Company was a pioneer in
developing oxygen conserving devices that enhance the quality of life for
patients by increasing their mobility and, at the same time, lower operating
costs by achieving significant savings in the amount of oxygen actually required
to properly oxygenate patients. The market for oxygen conserving devices has
been and continues to be significantly affected by increased competition,
consolidation among home oxygen dealers and revisions (and proposed revisions)
in governmental reimbursement policies. All of these factors, as described more
fully below, have contributed to a more competitive market for the Company's
products, as devices that were less expensive but which provided lower oxygen
savings (or, in some cases, did not truly provide ambulatory oxygen) have
achieved some level of success.
The current procedures for reimbursement by Medicare for home oxygen services
provide a prospective flat fee monthly payment based solely on the patient's
prescribed oxygen requirement. Under this system, inexpensive concentrators have
grown in popularity because of low cost and less frequent servicing
requirements. At the same time, oxygen conserving devices, such as the Company's
products, have also grown in popularity due to their ability to extend the life
of oxygen supplies and reduce service calls by dealers, thereby providing
improved mobility for the patient and cost savings for dealers.
In addition, other changes in the health care delivery system, including the
increase in the acceptance and utilization of managed care, have stimulated a
significant consolidation among home oxygen dealers. Major national and regional
home medical equipment chains have continued to expand their distribution
networks through the acquisition of independent dealers in strategic areas.
Margins on sales to national chains are generally lower due to quantity pricing
and management anticipates continued downward pressure on its average selling
price. Four major national chains accounted for approximately 49%, 47%, and 39%
of the Company's net sales, for the years ended March 31, 2004, 2003 and 2002,
respectively. One chain accounted for 27%, 24% and 23% of sales in the years
ended March 31, 2004, 2003 and 2002, respectively and one other chain accounted
for 14% and 11% of sales in the years ended March 31, 2004 and 2003,
respectively.
The Company believes that price competition, continuing industry consolidation
and competitive products with features not found in the Company's products prior
to the introduction of the OM-400 and CYPRESS OXYPneumatic(R) series conservers
discussed below adversely affected sales during the three years ending March 31,
2001. To combat the erosion in sales of the oxygen conserver product line, the
Company developed and introduced several new products in this area. The first of
these, the OXYMATIC(R) 401 conserver, received 501(k) clearance from the Food
And Drug Administration in June 2000, and shipments of the new product began in
July 2000. The second, the OXYMATIC 411 conserver, was cleared in December 2000
and shipments began in January 2001. The third, the OXYMATIC 401A and 411A
conservers, received clearance in March 2001 with shipments beginning that
month. The SEQUOIA OXYMATIC 300 series conservers began shipping in December
2001, and the Company began shipment of CYPRESS OXYPneumatic conserver in July
2002. Management believes the features and improvements in these products have
enabled the Company to regain some of the market share lost in the conserver
market prior to 2001 and reestablish the Company as a leader in the conserver
market.
In May of 2004 the Company received clearance from the FDA to market its new
SAGE(TM) Oxygen Therapeutic Device. The SAGE device is the first in a planned
family of oxygen therapeutic devices that use the Company's proprietary
technologies to sense a patient's movements and automatically adjust the rate of
oxygen delivery to reduce the risk of desaturation as activity increases. This
device combines the industry's first truly dynamic delivery technology with the
proven oxygen sensor technology in the OXYMATIC 400 series conservers. As a
result, the new SAGE Oxygen Therapeutic Device addresses the common problem of
oxygen desaturation, which causes a patient to feel weak and out of breath when
activity increases, while it still maximizes patient ambulatory capability. This
new device underscores the Company's dedication to providing home care suppliers
and their patients with the widest range of home oxygen choices to suit
individual needs, preferences and disease conditions. No estimate can currently
be made regarding the level of success the Company may achieve with this line of
products or when the additional therapeutic devices based on this advanced new
platform that are now in development may be introduced to the market. For
information that may affect the forward-looking statements made in this
paragraph about products under development, see Outlook: Issues and Risks - New
Products.
In 1998, the Company introduced the TOTAL O2(R) Delivery System, which provides
stationary oxygen for patients at home, portable oxygen, including an oxygen
conserving
14
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATION
device for ambulatory use, and a safe and efficient mechanism for filling
portable oxygen cylinders in the home. This provides home care dealers with a
means to reduce their monthly cost of servicing patients while at the same time
providing a higher quality of service by maximizing ambulatory capability. The
Company received clearance in November 1997 from the Food and Drug
Administration to sell this product. Initial sales of the TOTAL O(2) system were
adversely affected by several factors, including the overall home oxygen market
climate as well as start-up manufacturing and related supplier quality issues.
The Company has taken a number of steps to resolve the manufacturing and
supplier issues and now believes the success of this product will be dependent
on the healthcare community's acceptance of this technology and willingness to
substitute a higher capital acquisition cost for lower operating costs. While
the Company will continue its efforts to promote this product, based on sales
levels through March of 2003, the Company wrote off the unamortized license fees
related to the TOTAL O(2) system in March 2003.
During the past three years, the Company has recovered substantial market share
in the conserver market and is using that platform to spearhead its growth
strategy for the future, which includes the following:
- - Development of additional oxygen conserver models, such as the CYPRESS
OXYPneumatic conserver introduced in July 2002, that diversify the product
line in order to offer customers a range of oxygen conservation choices;
- - A continued promotional and educational campaign with respect to the
benefits of the TOTAL O(2) system, coupled with an ongoing emphasis on
improving the performance of component suppliers; and
- - An effort to expand the Company's product lines and improve existing
products through the investment in and development of new technologies,
such as proprietary sensor technology and control software licensed in
January of 2003 and the introduction of the SAGE Oxygen Therapeutic Device
in May 2005. These new technologies will provide the Company with an
opportunity to expand its oxygen delivery product lines and potentially
enter the highgrowth sleep disorder market.
While the turnaround measures of the past three years have had a positive impact
and management believes the current growth strategy should continue to enhance
the Company's competitive position and future operating performance, no
assurances can be given that these objectives will be achieved. Management of
the Company will continually monitor the success of these efforts and will
attempt to remain flexible in order to adjust to possible future changes in the
market for respiratory care devices. For information that may affect the outcome
of forward-looking statements in this Overview regarding the Company's business
strategy and its introduction of new products, see Outlook: Issues and Risks -
New Products, Consolidation of Home Care Industry, Competition, Rapid
Technological Change, and Potential Changes in the Administration of Health
Care, beginning on page 16 of this Report.
RESULTS OF OPERATIONS
Sales for the years ended March 31, 2004 and 2003 increased by $2,000,000
(10.2%) and $535,000 (2.8%), respectively, as compared to prior years. The
primary driver of the Company's increase in sales has been the significant
growth in sales of its conservers, largely as a result of the introduction of
the OXYMATIC 400 series conservers and CYPRESS OXYPneumatic conserver.
Management believes that the performance features of these conservers have
enabled the Company to recapture significant market share. Domestic unit sales
of conservers for the year ended March 31, 2004, increased 25%, over the prior
year, while the increase in domestic revenues from conserver sales was 14%. This
resulted from price reductions, the impact of national chain contract pricing
(see above), and the generally lower pricing for pneumatic conservers in the
marketplace.
Sales to foreign distributors represented 5% of total sales for the years ended
March 31, 2004 and 2003, and 6% of total sales for the year ended March 31,
2002. Management expects an increase in sales to foreign distributors during the
upcoming twelve months, however, quarter-to-quarter sales may fluctuate
depending on the timing of shipments. All foreign sales, with the exception of
Canada, are denominated in US dollars. Sales in Canada represent less than 2% of
total sales.
Cost of sales as a percent of net sales decreased from 57.3% to 56.1% and from
62.3% to 57.3% for the two years ended March 31, 2004 and 2003, respectively, as
compared to the prior year periods. This was a result of increased sales volume
and the change in the product mix, as the TOTAL O(2) system has a lower gross
profit margin than conservers.
Selling, general and administrative expenditures decreased from 40.0% to 33.5%
of net sales for year ended March 31, 2004 as compared to the prior year. The
Company's cost reduction efforts over the past two years have helped align
staffing and operating expenses more closely with current sales expectations,
but were offset to some extent by commissions paid to the Company's field sales
force of manufacturer's representatives. Selling, general and
15
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATION
administrative expenditures increased from 32.8% to 40.0% of net sales for year
ended March 31, 2003 as compared to the prior year. The increase was the result
of variable selling expenses that fluctuate directly with sale volume, $165,000
in proxy contest expenses incurred in fiscal 2003 and a $934,000 write down of
unamortized license fees related to the TOTAL O(2) system. Research and
development expenses increased by $303,000 and $170,000 for the years ended
March 31, 2004 and 2003, respectively, as compared to the prior years.
Currently, management expects research and development expenditures to total
approximately $1,570,000 in the fiscal year ending March 31, 2005, on projects
to enhance and expand the Company's product line.
On July 31, 2002, a national chain accounting for less than 10% of sales in 2003
filed a Plan of Reorganization under Chapter 11 of the United States Bankruptcy
Code (the "Plan"). The Plan provided for full repayment to the Company, and the
Bankruptcy Court has approved the Plan. Payments to the unsecured creditors
commenced on July 1, 2003. No assurance can be given that all of the payments
will be made as proposed under the Plan. As of March 31, 2004, this chain was
indebted to the Company for approximately $89,000.
At March 31, 2004, the Company had fully utilized its net operating loss
carrybacks and federal net operating loss carry forwards and had approximately
$2,785,000 in California net operating loss carryforwards. As a result of the
valuation allowances placed on the net operating loss carryforwards and deferred
tax assets, these net operating loss carryforwards and deferred tax assets will
be available to offset future income tax expense when and if the Company
generates additional taxable income. In December 2002, California enacted
legislation that suspends the utilization of net operating loss carryforwards
during tax years starting 2002 and 2003 effective retroactively back to January
1, 2002. As a result, the Company will be unable to use its California net
operating loss carryforwards until the tax year beginning April 1, 2004.
FINANCIAL CONDITION
At March 31, 2004, the Company had cash totaling $2,708,000 or 20.8% of total
assets, as compared to $1,596,000 (13.0% of total assets) at March 31, 2003. Net
working capital increased from $8,224,000 at March 31, 2003 to $9,175,000 at
March 31, 2004. Net accounts receivable increased $394,000 during the year ended
March 31, 2004, due to the increase in sales. For information regarding the
reorganization proceedings of one of our customers, please see the discussion in
Results of Operations. Future increases or decreases in accounts receivable will
generally coincide with sales volume fluctuations and the timing of shipments to
foreign customers. During the same period, inventories decreased $522,000. The
Company attempts to maintain sufficient inventories to meet its customer needs
as orders are received. Thus, future inventory and related accounts payable
levels will be impacted by the ability of the Company to maintain its safety
stock levels. If safety stock levels drop below target amounts, then inventories
in subsequent periods will increase more rapidly as inventory balances are
replenished. Currently, inventory balances are generally near safety stock
levels. For the year ended March 31, 2003, cash flow from operations were
augmented by $995,000 in income tax refunds.
The Company depends upon its cash flow from operations to meet its capital
requirements. Management believes cash balances and funds derived from
operations should be adequate to meet the Company's near and long term cash
requirements given the recent recovery of market share of oxygen conservers.
Cash derived from operations will depend on the ability of the Company to
maintain profitable operations and the timing of increases in receivables and
inventories. If profitable operations do not continue, the Company may need to
seek other sources of working capital. The Company has no established lines of
credit or other arrangements in place to obtain working capital and no assurance
can be given that if and when needed other sources of working capital would be
available. The Company expects capital expenditures during the next twelve
months to be approximately $1,250,000.
The following table aggregates all of the Company's material contractual
obligations as of March 31, 2004:
PAYMENTS DUE BY PERIOD
-----------------------------------------------------------------
Contractual Less than 1 1-3 3-5 After 5
Cash Obligations Total Year Years Years Years
- ---------------- ----- ---- ----- ----- -----
Operating lease obligations 1,828,000 406,000 1,309,000 113,000 --
Operating lease commitments consist primarily of a real property lease for our
corporate office, as well as minor equipment leases. Payments for these lease
commitments are provided for by cash flows generated from operations. Please see
Note 8 to the financial statements.
The Company does not have any debt and is not subject to any covenants or
contractual restrictions limiting its operations. The Company has not adopted
any programs that provide for post employment retirement benefits, however, it
has on occasion provided such benefits to
16
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATION
individual employees. The Company does not have any off balance sheet
arrangements with any special purpose entities or any other parties, does not
enter into any transactions in derivatives and has no material transactions with
any related parties.
SIGNIFICANT ACCOUNTING POLICIES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ significantly from
those estimates under different assumptions and conditions. Management believes
that the following discussion addresses the accounting policies and estimates
that are most important in the portrayal of the Company's financial condition
and results.
Allowance for doubtful accounts - the Company provides a reserve against
receivables for estimated losses that may result from our customers' inability
to pay. The amount of the reserve is based on an analysis of known uncollectible
accounts, aged receivables, historical losses, and creditworthiness. Amounts
later determined and specifically identified to be uncollectible are charged or
written off against this reserve. The likelihood of material losses is dependent
on general economic conditions and numerous factors that affect individual
accounts.
Inventories - the Company provides a reserve against inventories for excess and
slow moving items. The amount of the reserve is based on an analysis of the
inventory turnover for individual items in inventory. The likelihood of material
write-downs is dependent on customer demand and competitor product offerings.
Intangible and long-lived assets - The Company assesses whether or not there has
been an impairment of intangible and long-lived assets in evaluating the
carrying value of these assets. Assets are considered impaired if the carrying
value is not recoverable over the useful life of the asset. If an asset is
considered impaired, the amount by which the carrying value exceeds the fair
value of the asset is written off. The likelihood of a material change in the
Company's reported results is dependent on each asset's ability to continue to
generate income, loss of legal ownership or title to an asset and the impact of
significant negative industry or economic trends.
Deferred income taxes - the Company provides a valuation allowance to reduce
deferred tax assets to the amount expected to be realized. The likelihood of a
material change in the expected realization of these assets depends on the
Company's ability to generate future taxable income.
OUTLOOK: ISSUES & RISKS
The report contains forward-looking statements, which reflect the Company's
current views with respect to future events and financial performance. These
forward-looking statements are subject to certain risks and uncertainties, which
may cause actual operating results to differ materially form currently,
anticipated results. Among the factors that could cause actual results to differ
materially are the following:
DEPENDENCE UPON A SINGLE PRODUCT LINE
Although the Company currently markets a number of products, these products
comprise a single product line for patients requiring supplementary oxygen. The
Company's future performance is thus dependent upon developments affecting this
segment of the health care market and the Company's ability to remain
competitive within this market sector.
NEW PRODUCTS
The Company's future growth in the near term will depend in significant part
upon its ability to successfully introduce new products. In recent years, the
Company has introduced the OXYMATIC 400 series, the SEQUOIA and CYPRESS
OXYPneumatic conservers, and the TOTAL O(2) Delivery System and in May 2004
introduced the SAGE Oxygen Therapeutic Device; the Company is currently
developing additional new products. The success of the Company's products will
depend upon the health care community's perception of such products'
capabilities, clinical efficacy and benefit to patients as well as obtaining
timely regulatory approval for new products. In addition, prospective sales will
be impacted by the degree of acceptance achieved among home oxygen dealers and
patients requiring supplementary oxygen. As with any product, the Company's
ability to successfully promote new products cannot be determined at this time.
17
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATION
CONSOLIDATION OF HOME CARE INDUSTRY
The home health care industry is undergoing significant consolidation. As a
result, the market for the Company's products is increasingly influenced by
major national chains. Four major national chains accounted for 49% of the
Company's net sales during the year ended March 31, 2004. Future sales may be
increasingly dependent upon a limited number of customers, which may reduce our
average selling price due to quantity pricing.
For information regarding the reorganization proceedings of one our customers,
please see the discussion in "Results of Operations".
COMPETITION
CHAD's success in the early 1990's has drawn competition to vie for a share of
the home oxygen market. These new competitors include both small and very large
companies. While the Company believes the quality of its products and its
established reputation will continue to be a competitive advantage, some
competitors have successfully introduced lower priced products that do not
provide oxygen conserving capabilities comparable to the Company's products.
Most of these competitors have greater capital resources than the Company. No
assurance can be given that increased competition in the home oxygen market will
not have an adverse affect on the Company's operations.
RAPID TECHNOLOGICAL CHANGE
The health care industry is characterized by rapid technological change. The
Company's products may become obsolete as a result of new developments. The
Company's ability to remain competitive will depend to a large extent upon its
ability to anticipate and stay abreast of new technological developments related
to oxygen therapy. The Company has limited internal research and development
capabilities. Historically, the Company has contracted with outside parties to
develop new products. Some of the Company's competitors have substantially
greater funds and facilities to pursue research and development of new products
and technologies for oxygen therapy.
POTENTIAL CHANGES IN ADMINISTRATION OF HEALTH CARE
A number of bills proposing to regulate, control or alter the method of
financing health care costs have been discussed and certain such bills have been
introduced in Congress, including various proposals for competitive bidding, and
various state legislatures. Because of the uncertain state of health care
proposals, it is not meaningful at this time to predict the effect on the
Company if any of these proposals is enacted.
Approximately 80% of home oxygen patients are covered by Medicare and other
government programs. Federal law has altered the payment rates available to
providers of Medicare services in various ways during the last several years. In
November of 2003, Congress enacted the Medicare Improvement and Modernization
Act, which will cause changes and reductions in home oxygen reimbursement over
the next several years. These changes in reimbursement will cause increased
downward pressure on the average selling price of the Company's products.
PROTECTION OF INTELLECTUAL PROPERTY RIGHTS
The Company pursues a policy of protecting its intellectual property rights
through a combination of patents, trademarks, trade secret laws and
confidentiality agreements. The Company considers the protection of its
proprietary rights and the patentability of its products to be significant to
the success of the Company. To the extent that the products to be marketed by
the Company do not receive patent protection, competitors may be able to
manufacture and market substantially similar products. Such competition or
claims that the Company's products infringe the patent rights of others could
have an adverse impact upon the Company's business.
PRODUCT LIABILITY
The nature of the Company's business subjects it to potential legal actions
asserting that the Company is liable for damages for product liability claims.
Although the Company maintains product liability insurance in an amount which it
believes to be customary in the industry, there is no assurance that this
insurance will be sufficient to cover the cots of defense or judgments which
might be entered against the Company. The type and frequency of these claims
could have an adverse impact on the Company's results of operations and
financial position.
AVAILABILITY AND RELIABILITY OF THIRD PARTY COMPONENT PRODUCTS
The Company tests and packages its products in its own facility. Some of its
other manufacturing processes are conducted by other firms; the Company expects
to continue
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATION
using outside firms for certain manufacturing processes for the foreseeable
future and is thus dependent on the reliability and quality of parts supplied by
these firms. From time to time, the Company has experienced problems with the
reliability of components produced by third party suppliers. The Company's
agreements with its suppliers are terminable at will or by notice. The Company
believes that other suppliers would be available in the event of termination of
these arrangements. No assurance can be given however that the company will not
suffer a material disruption in the supply of parts required for its products.
ACCOUNTING STANDARDS
Accounting standards promulgated by the Financial Accounting Standards Board
change periodically. Changes in such standards may have an impact on the
Company's future financial position.
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations (SFAS No. 143), SFAS No. 143 requires the Company to record the fair
value of an asset retirement obligation as a liability in the period in which it
incurs a legal obligation associated with the retirement of tangible long-lived
assets that result from the acquisition, construction, development and/or normal
use of the assets. The Company adopted SFAS No. 143 on April 1, 2003. The
Company does not currently have any assets affected by SFAS No. 143.
In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections
which requires that the extinguishment of debt not be considered an
extraordinary item under APB Opinion No. 30, Reporting the Results of Operations
- - Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions,
unless the debt extinguishment meets the unusual in nature and infrequency of
occurrence criteria in APB 30. SFAS No. 145 is effective for fiscal years
beginning after May 15, 2002. The Company adopted SFAS No. 145 on April 1, 2003
and there was material impact on the Company's financial condition or results of
operations.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation
addresses the consolidation by business enterprises of variable interest
entities as defined in the Interpretation. The Interpretation generally applies
immediately to variable interests in variable interest entities created after
January 31, 2003 and to variable interests in variable interest entities
obtained after January 31, 2003. The application of this Interpretation did not
have a material effect on the Company's financial statements. In December 2003,
the FASB revised FIN 46 to exempt certain entities from its requirements and to
clarify certain issues arising during the implementation of FIN 46. The adoption
of this revised interpretation did not have any impact on our financial
statements.
In May 2003, the Financial Accounting Standards Board issued Statement No. 150,
"Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity" (SFAS No. 150). The statement establishes standards for
how an issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. It requires that an issuer
classify a financial instrument that is within its scope as a liability (or an
asset in some circumstances). It is effective for financial instruments entered
into or modified after May 31, 2003, and otherwise is effective at the beginning
of the first interim period beginning after June 15, 2003. We adopted this
standard effective July 1, 2003, and it did not have a material effect on the
Company's financial statements.
ADDITIONAL RISK FACTORS
Additional factors, which might affect the Company's performance, may be listed
from time to time in the reports filed by the Company with the Securities and
Exchange Commission.
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CORPORATE DATA
OFFICERS CORPORATE DATA
THOMAS E. JONES CORPORATE HEADQUARTERS
Chairman 21622 Plummer Street
EARL L. YAGER Chatsworth, CA 91311
Chief Executive Officer, President, (818) 882-0883
and Secretary LEGAL COUNSEL
TRACY A. KERN Square, Sanders & Dempsey LLP
Chief Financial Officer AUDITORS
OSCAR J. SANCHEZ KPMG LLP
Vice President, Business Development Los Angeles, California
ALFONSO DEL TORO TRANSFER AGENT AND REGISTRAR
Vice President, Manufacturing American Stock Transfer Company
KEVIN MCCULLOH 40 Wall Street
Vice President, Engineering New York, NY 10005
ERIKA LASKEY
Vice President, Sales and Marketing
DIRECTORS
THOMAS E. JONES
Chief Executive Officer
CHAD Therapeutics, Inc.
EARL L. YAGER
President
CHAD Therapeutics, Inc.
NORMAN COOPER
Retired Chairman
Kallir, Philips, Ross, Inc.
JOHN C. BOYD
Retired
PHILIP T. WOLFSTEIN
Managing Director
P.M. Global Foods, LLC
JAMES M. BROPHY
Senior Vice President
Truman Medical Centers
KATHLEEN M. FISHER
Chief Financial Officer
Sonic WALL, Inc.
COMMON STOCK PRICE RANGE
Beginning August 3, 1993, the Company's common shares were traded on the
American Stock Exchange Emerging Company Marketplace and on June 6, 1994, the
Company's shares moved to the primary list of the American Stock Exchange with
the symbol CTU. The following table sets forth, for the periods indicated, the
high and low closing prices as furnished by the American Stock Exchange.
QUARTER ENDED HIGH LOW
- ------------- ---- ---
June 30, 2002............................................... 3.61 2.26
September 30, 2002.......................................... 3.24 2.10
December 31, 2002........................................... 3.10 1.85
March 31, 2003.............................................. 2.30 1.25
June 30, 2003............................................... 2.13 1.63
September 30, 2003.......................................... 2.30 1.70
December 31, 2003........................................... 2.95 1.97
March 31, 2004.............................................. 3.60 2.32
As of June 12, 2004, there were approximately 257 shareholders of record and
approximately 2,500 beneficial owners of the Company's common stock. No cash
dividends have been paid on the common stock.
SEC FORM 10-K
A copy of the Company's annual report to the Securities and Exchange Commission
on Form 10-K is available without charge upon written request to:
Chief Financial Officer
CHAD Therapeutics, Inc.
21622 Plummer Street
Chatsworth, CA 91311
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